Streetwise

Lauren Rudd

Sunday, March 24, 2013

Butterfly Wings and Cyprus

There is an often quoted saying that a butterfly flapping its wings in one part of the world could cause a disruption in the weather a thousand miles away. While many take this aphorism at face value despite its incredulous facet, there lies within it a basic nugget of truth.

Originally titled “The Butterfly Effect,” the concept originated with MIT meteorologist Edward Lorenz.  In 1961, while an assistant professor at MIT, Lorenz created an early computer program to simulate weather. One day he changed one of a dozen numbers representing atmospheric conditions, from .506127 to .506.

That tiny alteration utterly transformed his long-term forecast, a point Lorenz wrote about in his 1972 paper, "Predictability: Does the Flap of a Butterfly's Wings in Brazil Set-off a Tornado in Texas?"

Lorenz’s butterfly effect was merely intended to illustrate the concept that small events can have large, widespread consequences. As such the butterfly effect has become a metaphor for the existence of seemingly insignificant moments in time that alter history and shape destinies.

Fast forward to the recent decline of the S&P 500 index after the parliament of Cyprus was subjected to and subsequently rejected, a proposed tax on bank deposits.

Yes, Cyprus is in difficult position, having been a major Greek bondholder. When the second Greek bailout package torpedoed Greek bonds, it caused a 4.5 billion euro ($5.9 billion) hole in the Cypriot budget. The tax is a condition of a European bailout.

At the same time Cyprus is a known haven for the wealthy and in particular wealthy Russians, who take advantage of its low corporate taxes and a financial environment light on regulation. In 2011, Russians “invested” $119.7 billion in Cyprus, nearly five times the island’s GDP, according to the money laundering watch dog group, Global Financial Integrity.

Today, Russian bank deposits are probably in the neighborhood of between 20 to 25 billion euros ($25.9 to $32.4 billion), or nearly a third of all Cypriot deposits.

Nonetheless, it seems the butterfly flapped its wings and the result was a drop in the market cap of some of our nation’s largest corporations, all because Cyprus might levy a tax of 7.5 billion Euros ($10 billion) on bank deposits. In contrast, Wall Street rallied despite the fears emanating from the sequester cuts and the resultant $81 billion reduction in federal spending.

Talk about irrationality. Do you really believe Cyprus’s actions justify a one percent decline in Exxon’s share price? It is nuts to think that because of Cyprus, Exxon should now be valued $4 billion dollars less than a week prior. Especially when you consider that every week Exxon chalks up about $800 million in profits.

At the same time, Morgan Stanley fell 2.5 percent, roughly a $1 billion decline in market cap. If you previously liked Morgan Stanley then the 2.5 percent discount should have been a barn burner.

Did the Cyprus tax justify removing $1 billion from the market capitalization of Johnson & Johnson? The company has an AAA credit rating, a rating higher than that of the Federal Government. Suddenly Johnson & Johnson is on sale despite a dividend yield of 3.6 percent, an ROE of 17 percent and operating free cash flow of $15 billion, all because little Cyprus. What a time to go shopping. And thanks to the world of butterflies.

As I wrote last week, the world has no shortage of crises. Yet, maintaining a pragmatic vista does not imply any lesser degree of concern. You simply want to avail yourself of the opportunities created by irrational panic flows of capital. To put it bluntly, the Street’s antics should not be an impediment to your investment strategy. Rather just the opposite.